Does Governance Travel Around the World?

The following post comes to us from Reena Aggarwal, Professor of Finance at Georgetown University’s McDonough School of Business; Isil Erel of the Finance Department at The Ohio State University; Miguel Ferreira of the NOVA School of Business and Economics; and Pedro Matos of the Finance Department at the University of Southern California.

In our paper Does Governance Travel Around the World? Evidence from Institutional Investors, forthcoming in the Journal of Financial Economics, we examine whether institutional investors affect corporate governance by analyzing portfolio holdings of institutions in companies from 23 countries during the period 2003-2008.

We find that international institutional investors export good corporate governance practices around the world. In particular, foreign institutional investors and institutions from countries with strong shareholder protection are the main promoters of good governance outside of the U.S. Our results are stronger for firms located in civil-law countries. Thus, international institutional investment is especially effective in improving governance when the investor protection in the institution’s home country is stronger than the one in the portfolio firm’s country.

Our results suggest that it is changes in institutional ownership over time that drive changes in firm-level governance, but the opposite is not true. We also provide evidence that institutional ownership has a direct effect on corporate governance outcomes, functioning as a disciplinary mechanism in terminating poorly performing CEOs. Furthermore, increases in institutional ownership lead to increases in firm valuation, suggesting that institutional investment not only affects governance mechanisms, but also has real effects on firm value and board decisions.

To our knowledge, our paper is the first to establish a direct link between international portfolio investment and the adoption of better corporate governance practices that promote corporate accountability and decision making. Our findings support the view that institutions are not simply attracted to firms with stronger governance, but they also play a direct role in improving governance. Foreign institutions take a lead role in improving governance and shareholder activism that local investors seem unable to take in many countries.

A particular aspect of foreign institutions that seems to be important is their independence with respect to local corporate managers. We conclude that monitoring and activism by institutions travel beyond country borders and lead to better firm performance. Our findings highlight that market forces (namely institutional investors) are able to promote good corporate governance practices around the world beyond the effect of government regulations.

The full paper is available for download here.

Both comments and trackbacks are currently closed.